The 5 Key Trends in Capital Structure for 2021

Running head: TRENDS IN CAPITAL STRUCTURE 1 1 

Trends in Capital Structure 

Student’s Name 

Institutional Affiliation 

Trends in Capital Structure 

Introduction 

In the contemporary business setting, the cost structure of firms is determined by both internal and external factors. The current research paper critically explores the trends of the capital structure of firms in the automotive sector. To attain this, the essay will analyze the capital structure of the Ford Motor Company, Toyota Corporation, and General Motor Company anchored on the tradeoff theory. According to Çerkezi (2013), the theory indicates that there is an optimal capital structure that strikes a balance between costs and benefits. Therefore, the long term capital structure of the three firms will be determined and factors that have driven these trends and conclude by establishing whether the trend will persist or not 

1.0 Background of the Companies 

General Motor Company (GM) 

General Motor Company (GM) is a global giant that has its headquarters in Detroit, Michigan. The firm is commonly known as GM, and it was incorporated in 2009 after the bankruptcy of the General Motor Corporation. GM designs manufactures and sell trucks, crossover, cars, and automobile part globally. Besides, the firm offers automotive financial services through different subsidiaries. Predominantly, the company has reported profit since the year 2010 onwards, whereby it was ranked second after selling more than eight million units. In 2011, the company was first after selling more than nine million units, which represented more than 11% of the market share of the motor industry (General Motor Company, 2012). Overall, the company has managed to maintain a solid financial structure funded by both equity and debt. 

Ford Motor Company (Ford) 

Ford Motor Company, commonly known as Ford, is a global giant in the automotive sector, which has its headquarter in Dearborn, Michigan. Henry Ford formed the company, and it was incorporated in June of 1903. The firm is in the business of designing, manufacturing, selling, and servicing of full line Ford cars, trucks, and sport utility vehicles (SUVs). The firm operates four segments; automotive, financial service, Ford smart mobility, and central treasury operation (Reuters, 2019). The automotive division deals with designing, manufacturing, and selling of Ford Vehicle in America and other parts of the globe. The financial division majorly deals with vehicle-related to financing, leasing, and insurance. Unlike GM, the company survived the global recession of 2008/9, and this has allowed Ford to command a significant market share. 

Toyota Corporation 

The global giant was founded in 1937 and has it headquarter in Toyota, Japan. The company design, manufacture, assemble, and the sales of passenger cars, minivans, commercial vehicles, and spare parts as well. As of 2013, Toyota was the largest auto manufacturer and eighth-largest company in the world. The company reported $ 213 billion annual revenues, with more than 0.3 million employees (Nkomo, n.d). In the last decade, the company has shifted its focus from the production of fuel-guzzling pickup trucks to more efficient cars. The skyrocketing of fuel prices, coupled with growing environmental concern, is the primary reason for this strategic move. Compared to Ford and GM, Toyota was the company that encountered the least impact due to the global recession of 2008/9 (Nkomo, n.d). Overall, the company's profitability has increased steadily in the last decade due to the increased demand for their products all over the globe. 

3.0Analysis of Historical and Projected Data 

To determine the capital structure trend in the motor vehicle manufacturing industry, it is vital to have a closer look at the internal performance of the companies. The analysis will focus on sales, cost of goods sold, and the earning before, tax, depreciation, and amortization (EBITDA) from 2010 to 2014. The capital structure largely influences the parameters, and therefore, they will provide an overview of the trends in the motor vehicle sector. 

3.1 Sales and Sales Growth 

Unquestionably, since the year 2010, the automotive industry has witnessed tremendous growth. In particular, the sales of the three global giants have increased, and the manufacturing capacity has also expanded. The unprecedented growth has been linked to economic growth and low interest rates after the 2008/9 financial meltdown. Figure one provides an overview of the sales of the three companies in the last five years and project growth using a 3 % growth rate 

Figure One: Sales of Ford, GM, and Toyota from 2010-2014 and projection of 2015-2019 

The figure above indicated that the sales of the three companies had increased steadily in the last five years. The strategic decision to focus on consumer trends and fuel efficiency were the main reasons that increased GM sales in the last five years (General Motor Company, 2011, 2012 & 2014). On the other hand, adopting better production standards and the manufacturing of fuel-efficient vehicles contributed to the increase in sales of Ford (Ford Motor Company, 2012). Nevertheless, Toyota registered a slight fluctuation in revenues in the last five years. The company registered the highest profit in 2013, but a decline followed the following year. According to Turtle (2015), the decline was associated with the dismal performance of Toyota Prius in the first eleven months and the launching of the Tesla Model in the U.S, which captured a significant portion of the Toyota market. Overall, Toyota has recorded excellent performance compared to the other companies. Notably, the company move to expand its manufacturing operations to Mexico and China has allowed it to plummet the production costs, and eventually increase profitability. 

Furthermore, the three companies have reported different rates of growth in the last five years, which is linked to the capital structure. The variability in sales in the financial years of 2010/12 of Toyota was primarily due to massive recalls of vehicles due to acceleration fault and the reduction in production as a result of the 2011 Tsunami. Although the sales of the company improved in 2012, the recall of vehicles due to the fault of the airbag in 2013 immensely reduces the sales growth in subsequent years. The sales growth of GM and Ford were much better compared to Toyota; for instance, between the year between 2013 and 2014, GM recorded the highest growth rate (Ford Motor Company, 2013: General Motor Company, 2014). Generally, the growth of the companies is expected to increase due to the availability of consumer credits, low cost of fuel, and the invention of effective production techniques. 

Figure Two: Sale Growth 

3.3 Cost Goods Sold (COG) 

In the automotive sector, the cost of goods sales encompasses a large portion of the overheads of the company. Therefore, this section will focus on the cost of goods sold ratio of the different companies and establish how they impact the cost structure in the automotive industry. The goods sold ratios of three companies will be used to determine the direct cost attributable to the final product. Markedly, a reduction in the COG outlines higher efficiency in the use of resources, while an increase highlights a possible cash-flow problem. The figure below indicates the COG of the company for five years and the projection of the same number of years. 

Figure three; Cost of sales and project 

In this aspect, GM recorded the highest ratio compared to the other two companies. The drop in sales of pickup trucks was the primary cause, as it increased inventory. The situation was further compounded by the increase of employee benefits, manufacturing expenses, and unfavorable vehicle mix (General Motor Company, 2014). On the other hand, Ford was performing way better than GM and Toyota, with a ratio of 77.9 % compared to the 82.3% and 81.3% of GM and Toyota, respectively. Nevertheless, in 2014, Toyota emerged the best, while GM was still struggling. The forecasted data was calculated using the average historical cost of goods sold over sales data. The projection of the five years indicated that the COGs to the sales ratio of these three companies would be at 81%, 84%, and 78%, respectively, for Ford, GM, and Toyota. The GM ratio was compounded by recalling older vehicles that had a problem with the engine, which increased the cost. Notably, Toyota has managed to maintain a high level of efficiency due to the low level of stock, which has largely been contributed by the adoption of the Just-in-Time inventory system (Toyota Motor Corporation, 2013). In other words, the COG outline the factors that have affected the cost structure of three automotive companies. 

3.4 Earnings before Interest, Taxes, Depreciation, and Amortization /Sales (EBITDA /Sales) 

EBITDA is a metric variation of the operating income that excludes non-operating costs and particular non-cash expenses. According to Brigham and Ehrhardt (2013), the goal of these deductions is to eliminate the aspect that the owner of the business has control over, such as the level of debt, equity structure, and depreciation method. Therefore, the analysis of this ratio is imperative as it touches on elements that affect the cost structure of the company. For example, the ratio excludes interest, which largely depends on the financing structure of the company. Taxes, which are created by the government, are also excluded from the ratio. In this case, historical data of the three companies was used to calculate the ratio for five years. 

Figure three: profit Margins 

According to figure three, Ford reported the highest profit margin between the financial year 2010 and 2013, but Toyota had the highest margin in the years 2013 and 2014. The two companies had witnessed a steady increase in profit margin due to increased sales and a reduction in the cost of production. Contrastingly, GM recorded a relatively low-profit margin of 4.23% in 2012. Erratic prices of fuel had affected consumer demand for SUVs, which plummeted GM’s profit margin. The dismal performance of the GM is expected to continue in the coming years unless the management focuses on the production efficiencies and cost reduction approached. 

However, Ford and Toyota are expected to rise steadily in the next five years. Therefore, the strategies adopted by the three companies to improve profit margin affects the cost structure. For instance, GM is recording a relatively low-profit margin, and the management needs to adopt better production techniques. This will, however, force the company to increase the debt to fund such projects. Conversely, Toyota is performing considerably well, and the company is making adequate revenue, which has allowed the company to expand its operation on other parts of the world, with necessarily increasing the debt. Evidently, the profitability of automobile companies largely influences the capital structure. 

4.0 Capital Structure Analysis and Choice 

As aforementioned, the capital structure of a company influence the internal operations of a firm, and the effect on profitability is undeniable. Therefore, this section explores the capital structure of the three automotive firms and ramifications on tax shield and bankruptcy. The analysis begins by determining the three capital structure of three firms, which are primarily funded by debt and equity. Figure four outlines the average percentage of debt of the three companies, whereby Ford uses more debt than equity, while GM and Toyota use more equity. It appears that Ford has limited choices of growing debt than GM and Toyota; however, more focus on bankruptcy costs and tax shield benefits will provide better insights on the capacity of each of those companies to issue more debts or more equity. 

Figure Four: Avenge Percentages of Debt to equity of Ford, GM, and Toyota 

Undeniably, the tax shield benefit on interest deductibility is the first aspect the cost analysis the paper will focus on. Table two calculations noted that the two American companies have a higher tax shield advantage that the Japanese firm. Ideally, the tax shield benefit of interest deductibility highlights the merits in less tax payment, which the organization has by growing its level of debt. The calculation has noted that GM has a higher tax shield benefit than other companies. For instance, in 2014, GM has benefited 25%, while Ford saved roughly 18% and Toyota only 0.3%. This, therefore, means that GM saved more of its profit before tax in 2014 than the other two companies, which eventually increased the net profit. 

To begin with, the reason that can explain this difference is that GM has a shallow effective tax rate of 5.53% compared to Fords’ 27% and Toyota’s 28.75%. The lower effective tax rate is the consequence of the tax break GM benefited after the U.S. government bailout during the financial meltdown of 2008/9. This low effective tax rate has a positive impact on GM because it increases the present value of the tax shield compared to the two other companies. Toyota and Ford have high a higher level of debt and this element combined with high tax cost results in greater present value of tax shield. Secondly, GM's higher benefit of tax shield is due to greater cost of capital, which increases the denominator of the tax obligation, hence, lowering the amount of tax obligation. Toyota has the lowest cost of capital, 3.05%, and Ford’s is 3.79, therefore have a higher tax obligation. 

TAX SHIELD BENEFITS 2015
	FORD	GM	TOYOTA
Cost of debt	2.93%	4.05%	0.12%
Cost of equity	7.02%	7.84%	5.18%
Effective Tax rate	27.42%	5.53%	28.75%
WACC	3.79%	6.01%	3.05%
PV of Tax Shield	32679.53162	2590.707	45476.7172
PV Tax Obligation	150759.2671	7793.11	15363650.5
Tax Shield Benefit	17.8%	24.9%	0.3%

Table One: Tax shield Benefits 

Notably, GM’s decision to increase its debt to 46% of assets from 37% the previous year, while Ford remained steady and Toyota decided to decrease to 42% from 47%, has enabled GM to save more taxes than its rivals. Thus, Ford saved 18% of its profit before tax and Toyota only 0.3%. These findings can encourage firms to increase their debts and decrease equity because of the more debt the companies contract, the more benefit they can have on tax savings. Nevertheless, according to Brigham and Ehrhardt (2013), the tradeoff theory prohibits from consistently increasing their debt to save money as bankruptcy costs can arise from high debts and offset the tax benefit. In this regard, companies opt to mix of debts and equity to maximize shareholders’ value. 

Undoubtedly maximizing shareholder wealth is a primary objective in the automotive sector, which is tremendously affected by the cost of capital. Therefore, to determine a common ground, whereby companies’ debt and equity will maximize shareholder wealth, the analysis will focus on the bankruptcy costs and compare them with benefits from tax deductions. According to Brigham and Ehrhardt (2013), bankruptcy cost arises when firms include a more considerable amount of debt in their capital structure, which creates two components; first is the chance of financial distress, and the second is the cost, which would be suffered if financial distress occurs. Therefore, to assess the risks of three firms, the analysis will determine the risk using two methods. The first method of default risk establishes the probability that EBITDA will not offset debt obligation during the next five years using the normal distribution method. This method assesses the probability that the average debt obligation could or could not be covered by the combination of the mean and standard deviation of the EBITDA. 

	FORD	GM	TOYOTA
NORMDIST	2.23382E-7	4.85069E-75	1.4628E-00

Generally, the possibility that either of the companies going bankrupt is relatively low since all the three firms show meager chances. Nonetheless, GM has the highest probability of going bankrupt with 4.85%, which makes perfect sense since it has the highest cost of debt, 4.05%. Toyota has the lowest probability of going bankrupt, and this can be explained by the fact that Toyota has the lowest cost of debt, 0.12%. Therefore, even though GM has a more significant Tax shield benefit, it needs to practice caution in leveraging debt because its bankruptcy cost is higher than its competitors. 

The other method as accessing bankruptcy cost using coverage ratios for the next five years. Brigham and Ehrhardt (2013) argued that a coverage ratio of 2 and more is a good indicator of financial health. The coverage ratio indicates the number of times a particular company’s EBITDA can cover its future debt obligations to prevent bankruptcy. In our case, all our companies have a coverage ratio greater than 2 for the next five years as shown in the chart below. Ford has its minimum coverage ratio of 4.91 in 2015 and the maximum 5.53 in 2019. GM has higher coverage ratios than Ford, with 6.48 and 7.29. This can be explained by the fact that Ford has more debt than GM does. For Toyota, coverage ratios are above 100 for the forecasted period meaning that despite the high level of debt of this company, the cost of debt is barely existent. Toyota acquires debt at only 0.12% on the Japanese market that has low costs of capital while its competitors are leveraging on the U.S., where the federal interest rate is higher than Japan’s. 

Figure Five: Coverage Ratio for Next Five years 

5. 0 Future Trends 

The analysis provides an overview of the cost structure in the automotive industry, which is mostly determined by both external and internal factors. The taxation policy adopted by the government affects the cost structure through the tax shield benefits. In the U.S, the tax shield is better, and companies should increase the debt in their capital structure. Additionally, other external factors, such as advancement in technology, affect the cost of the structure. For instance, Toyota has adopted better and efficient production techniques that have plummeted the cost of the company, which has increased profitability and eventually affecting the cost structure. Moreover, the general performance of the economy affected the cost structure: for example, the financial meltdown of 2008/9 tremendously affected the U.S companies. The analysis has outlined that these factors will continue to affect the cost of the structure of companies in the automotive sector. However, the environmental issue and changes in the market demand could have a larger impact in the future. 

6.0 Conclusion 

The analysis has focused on the internal and external factors that affect the cost structure. The three companies have shown different internal aspects, which is affected by external factors. Toyota and Ford have reported better performance compared to GM, and tax policy in the U.S has played a more significant impact. Although the three companies have a difference in performance, the analysis provides an overview of the cost structure in the automotive industry. 

References 

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